Have you ever heard of stories where others are able to reap tens of thousands a month without working at all? The amount of cash flow they receive is sufficient for them to retire comfortably at a relatively young age.
But if you are like most of us and do not possess a huge amount of capital, bringing in thousand-dollar passive income doesn’t seem like achievable in the near horizon.
Don’t worry, by the time you’ve read finish this article, we assure you that you will have a clearer direction on your journey towards financial freedom from dividend investing.
What is a dividend?
A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash, stock or other assets.
How and why does the company pay shareholders dividend?
A stock represents a fractional ownership of the company. If your company earns profit, you will probably face two choices – how much to keep (dividends) vs how much to reinvest (retained profits).
Keep a mental note about this! We will explore more about this important concept later.
“HPH Trust has a 12.78% dividend yield! I should probably invest in it.!”
There are many investors in the market who are only concerned with the yield of the company. While the yield from investing in HPH Trust is 12.78% on paper, do you have any clue where is the HK$2.27b distribution taken from? Is it purely from its annual earnings or is the company paying its shareholders from its cash reserves?
Turns out, if we have a look at the historical price of HPH Trust, we can see that the company is suffering from underperformance.
Especially when a company is not performing at all, a high level of dividends is often a clear red sign that you are looking in the wrong place.
If you blindly chase yields, your portfolio may wither away slowly.
High dividends = bad?
Of course not. The rule is that you should always fully understand about the company before deciding to invest or not.
The following are a few questions that may give you a reminder the next time you get excited over a company with high dividend yields.
- How high is the dividend yield?
- How much of the earnings are used to pay off the dividends?
- Why did they choose to pay dividends rather than to reinvest?
- Is the dividend payout sustainable?
- Has the company matured or is it at the point of the capital cycle where it is smart to return earnings back to shareholders?
If the company is able to pay such a high level of dividend solely due to its earning power, then you have to question whether that is a smart move.
Did the management run out of options or the ability to reinvest the earnings at a higher rate of return? Or like in the case of real estate investment trusts (REITs), some companies are encouraged to return the bulk of their earnings as dividends to enjoy tax cuts.
After determining that the reason behind the high dividend yield is innocuous, you are off to dig deeper into selecting quality dividend paying stocks for your portfolio.
The right business
What makes a good business great? There are many approaches and you should not confine yourself to the direction we (or anyone else, for that matter) are leading you!
Regardless, you must never deviate from a value investing philosophy. Without this in mind, you are abandoning safe returns and betting on your hard-earned savings!
Now, on to characteristics of a great business…
A great business should possess a competitive advantage in the industry they are in. Usually the stronger the advantage, the higher the profit margin and returns on equity. Some examples would be Coca-Cola, McDonald’s and American Express. These companies possess strong branding and influence which are intangible assets.
Incidentally, legendary value investor Warren Buffett has holdings in these companies as well.
No matter how enticing the underlying economics of the business is, a great business will not take off if poorly managed.
Professional fund managers have the authority and influence to call up top executives to understand more about the situation in the company. While most executives would be trying to hard-sell the company, the sharp investor would be able to pick out tell-tale signs of a good management.
Unfortunately, most investors are not able to get on that level with the top executives. However, you are still able to garner a lot of useful information from observing corporate behavior such as share buybacks and conferences. Is the company being conservative and cautious in their forecasts or overpromising?
You have to be able to discern the substance from the ‘feel-good’ factor in the presentations before you can begin your analysis.
Relationship with suppliers
Most businesses involve an input and an output. The desirability of the end product and the availability of the input determines the profit margin the company can make.
If the company is able to acquire raw materials at a cheap price and sell the differentiated output at a high price consistently, it shows great potential to be a wonderful investment in the long run.
Having a good and sustainable relationship will value-add this process as the input becomes cheaper and predictable. While demand may fluctuate, you can at least forecast the supply.
Don’t forget price-value
As value investors, we should never forget the importance of intrinsic value. Without any reference point, how are we going to know whether the stock is too expensive or cheap? Just because you are investing for quality dividends, it doesn’t mean you should ignore valuation and price.
The value-price approach provides you with a greater margin of safety and a peace of mind at night. By taking a conservative estimate of the value, you are also able to have a sufficient buffer in case your forecasts go wrong where your dividends and capital doesn’t appreciate as much as expected.
What to do with your dividends?
Seeing the money ticking up in your bank account sure seems magical but don’t be quick to spend it all!
If you reinvest all your dividends in quality companies, you will reap much greater rewards in the future. You will be thanking yourself that you’ve made this decision in due time.
Seeking to learn more about value investing beyond dividend investing? Begin with reading our articles on what value investing is and how we see things differently from the rest!